Scheme excellence profile: USS

May 1, 2024 | Case Study

In the first of a new DCIF series documenting scheme excellence, USS’ head of investment product management, Naomi Clark, told Louise Farrand about the non-linearity of the scheme’s net zero journey, investing in private markets in the pandemic, and the surprising benefits of FX in DC

On USS’ private markets journey

A smiling woman with blonde hair wearing a white lace blouse, posing against a light gray background.While investing in private markets is a big part of the conversation in UK DC today, USS started looking at investing in private markets back in 2017/18. 2019 proved a pivotal year, with the scheme going live with its new investments in early 2020.

Naomi Clark, USS’ head of investment product management says: “You can see it was a long journey for us, even though we had a significant portion of our DB section in these assets and effectively owned them already.”

Much of the preparatory work involved getting comfortable with how private markets assets are priced and valued, and putting the mechanics in place so that members could trade in and out of the funds.

USS is fortunate in the sense that the academic sector tends to have similar payroll dates, so the scheme gets the majority of its contributions within the same few days of the month. To manage liquidity and valuations, USS deals monthly in private assets.

The long-term liquidity is managed by the fact that USS is a young DC scheme and cashflow positive. Clark says: “If we need to rebalance away from private markets, we can do that with contributions. We do have an extreme backstop we can use, which is where [USS’] DB [section] can help out the DC section. But on a day to day basis, we manage the liquidity using the cash flows that come in.”

Another issue the team worried about was communicating to members about private markets. Thankfully, they were soon reassured. Clark explains: “I think it’s inherently much easier to explain owning an asset like Heathrow or Moto that people can touch and see than it is explaining bonds, FX, equities, derivatives, that sort of thing, which are just esoteric concepts that most people don’t come across in their everyday lives.”

She recommends consumer focus groups to other schemes who are thinking through the member communications element of private markets. Through those groups, USS realised that explaining illiquidity was easier than the pensions industry tends to assume.

She adds: “The [research consultancy] Ignition House focus groups really showed that people were comfortable. They would independently come to conclusions about liquidity. So often in these focus group sessions, someone would say: ‘If you own Heathrow Airport, I guess you can’t just sell that tomorrow?’ And we would say: ‘No, you’ve got to wait for there to be a buyer. And that could take a long time.’ And then they would say: ‘Oh, so what do you do about that?’ We would explain that we have a diversified portfolio that helps us mitigate that risk and they understood that.”

Getting the governance right was a third challenge. Clark recalls: “We were the only scheme really doing this at the time and it was a big call for our trustee really to get comfortable with it. It took time, but they were very positive and supportive, which was really helpful.”

Going live in 2020 – the year the pandemic halted life as we knew it – was an unexpected early test for USS’ private markets strategy, especially as its infrastructure portfolio is transport heavy. Clark acknowledges: “It wasn’t the best year performance wise, but since then, we’ve seen some brilliant returns from the portfolio, and it is a long term investment.”

The pandemic was a stress test of the portfolio, she adds. The scheme couldn’t have predicted an event quite like it, but all the controls they had put in place worked as they were designed to.

While USS already invests across the spectrum, from private debt to property to natural capital, the scheme plans to increase its private markets portfolio by “potentially another five percent,” says Clark. “We hope to add different private asset classes. That’s a project we’re actively working on.”

USS’ net zero journey: it isn’t linear

Like its peers, USS has set a net zero ambition and interim targets – and it’s doing well on the journey. Asked what other schemes should focus on, Clark advises them to look at their data. “We have a complex pool of assets. The more data you have, the more you can understand about what you need to do. I think that also because of the reporting burden, like TCFD and TNFD, investing in being able to understand your exposures is probably one of the most important things you can do. It’s a really big focus for us.”

However, Clark is cautious about making any big net zero proclamations. “I think the thing we’re concerned about and why we’re not on our soapbox, is that a lot of the gains that we’ve made come down to big asset allocation shifts or, alternatively, single stock positions that can have a massive impact on your portfolio. They’re not decisions that we’ve made necessarily in order to achieve our targets, they are decisions we would have made regardless.”

Clark adds: “We are constantly talking to our trustee about how it’s not linear. Yes, we’ve had some good years and yes, we’ve decarbonised rapidly, but there are things that we could do tomorrow that would take us back and they might happen, because we’re always investing in the best financial interests of members.”

For example, USS recently divested from a cement manufacturer for financial reasons. The cement manufacturer was a highly carbon intensive business, so the divestment has incidentally made USS’ carbon intensity look better. Clark adds: “But someone else owns that company, and the company hasn’t changed. So, it’s out of our portfolio, but has it made any difference to the world? No.”

USS believes its efforts are better focused on engagement than divestment. Clark recently finished a project looking at responsible investment across USS and benchmarking the scheme against its global peers. This culminated in an ambition statement which, notably, states that USS will not attempt to diversify its way out of large systemic risks, or stock pick its way around them.

Clark explains: “When you’re a 70 billion-odd pound fund, you take on all the systemic risk of the market, there’s nothing you can do to avoid it. So, our ambition on responsible investment is to try and engage at the policymaker level to try to reduce systemic risk. And to engage in areas where we feel we can make a difference in responsible investment, rather than trying to make incremental changes.”

Fiduciary duty and its compatibility (or not) with responsible investment has long been discussed by the pensions community, with the debate hotting up as the need to act on climate change becomes more pressing. But Clark doesn’t see the two as mutually exclusive. “I think if you view responsible investment-related issues as a financial risk, and you resource yourselves to be able to deal with that risk, then you can deal with it – and that is the right thing to be doing for your members and for wider society. For me, the two things go hand in hand, and I think good investors are looking at those risks.”

The surprising benefits of FX

Clark is keen to emphasise the surprising benefits of FX to other DC schemes. In the past, like other DC schemes do, when USS invested in pooled funds, the scheme would buy a hedged or unhedged share class if it wanted to hedge or not hedge – in a similar way to how it invested in its defined benefit (DB) section. However, USS moved away from policy hedging in DB. “Now we see FX almost like its own asset class and we can use it as a risk management tool, but also as a way to improve risk/return outcomes,” says Clark.

She adds: “We’ve moved away from using externally managed funds and we now have a lot in either internally managed funds or segregated mandates, so then it’s not so easy to buy a hedge share cluster as well. Because we spent quite a lot of time thinking about the effects on the DB section, I think it felt like, ‘Well, why aren’t we doing this for DC?’ Even though it’s obviously not common at all to do it in DC.”

After some exploration, USS decided there was no good reason not to do the same in DC – and in fact, it has many benefits. Using derivatives as they would in a DB scheme, USS is able to dynamically manage its currency exposures. It works as an active risk management tool. Plus, “If you look historically, FX can be additive to returns if managed correctly,” says Clark.

The scheme is currently reviewing its investment glide paths and looking at FX exposure throughout a scheme member’s journey, including into retirement.

Clark reflects: “Obviously we work in a predominantly DB environment. I think it is quite easy for us to question, ‘Hold on, why aren’t we doing that for DC?’ For us, it’s also all about pushing that parity between the two sections of the scheme.” 

Would you like to take part in the DCIF’s scheme excellence series? Please email Louise Farrand: [email protected].



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